The collapse of Lehman Brothers this year highlighted the problem of counterparty risk for pension schemes trying to juggle their liabilities and risks, and forced trustees to think differently about the strategies they apply to protect their pension funds. While the volatile markets have wreaked havoc, investment consultants are confident that one hedging strategy – liability-driven investing – is holding up well in the financial crisis.

In recent years, trustees have become used to the idea that they can hedge against rises in benefit payments caused by future price inflation and higher interest rates by buying swaps.

But fears over the stability of banks that issue swaps – not least since the collapse of Lehman Brothers, a small but not insignificant participant in the UK swaps market – together with problems with the supply and rising costs of these instruments, are driving pension funds to revert to the older and simpler approach of buying bonds to help manage risk.

While it is difficult to put a figure on the size of the LDI market, since these are usually private, over-the-counter deals, investment consultancy Watson Wyatt said it advised its pension fund clients on roughly £14bn (€16.5bn) worth of LDI assets last year. Asset manager F&C said another £18bn worth of liabilities were covered in the first six months of this year.

Nick Horsfall, a senior consultant at Watson Wyatt, said: “It is a generalisation, but the vast majority of LDI swap strategies will be in the money by significant amounts. They have worked, and have provided mark-to-market protection against the liabilities. I can’t think of any of our clients that aren’t in the money.”

Andrew Tunningley, head of the UK investment practice at consultancy Hewitt Associates, agreed that funds that implemented risk hedges had largely enjoyed positive returns during the year to September 30, while those without such strategies had lost money.

The problem facing unprotected pensions funds, according to Glyn Jones, chief investment officer at P-Solve Asset Solutions, is that they have been hit by the “double-whammy” of assets moving in one direction and liabilities moving in the other.

Jones said: “Long dated interest-rates have fallen by 0.5 percentage-points over the past 12 months, which causes the economic value of the liabilities to increase by around 10% to 15%. We are looking at an effect equivalent to a 30% fall in the FTSE 100 for a typical pension scheme, just on interest rates alone.

“Coupled with that, there has also been a real 35% fall in the FTSE. Undiversified pension funds have been hit much worse than other investors because their benchmark – their liabilities – has gone up hugely in the past 12 months. LDI strategies aim to reduce the risk of underperformance as a result of strong [liability] benchmark performance.”

Swaps are products sold by investment banks, and they amount to agreements to exchange sets of future cashflows. Pension funds pay a fixed cash rate and receive payments linked to inflation or interest rates, neutralising the risk that those rates will move in unexpected ways.

But in the wake of Lehman’s collapse, consultants are warning that swaps never claimed to eliminate risk entirely. They merely exchange interest-rate and inflation risks for something else: counterparty risk, or the chance that the bank you have the agreement with collapses.

There is consensus that if Lehman had been a big participant in the UK swaps market – like Barclays, Morgan Stanley, Royal Bank of Scotland or Goldman Sachs – many more LDI strategies would have come unstuck. Watson Wyatt estimates only £500m to £1bn worth of pension funds’ swaps needed to be replaced.

Masroor Ahmad and Mark Davies, specialists in P-Solve’s risk management solutions team, said the rules and agreements governing swaps had dealt with the Lehman collapse reasonably well. Most pension funds’ swaps must be fully collateralised – meaning that both parties back the swap with cash or secure assets such as government bonds. If one of them collapses and leaves the other in the red, the injured party holds onto the cash, using it to buy fresh protection.

Ahmad said that in the earliest days of pension fund swaps, the view on collateralisation was affected by a low perceived awareness of counterparty risk coupled with banks struggling to understand pension funds’ creditworthiness because they are often in deficit. He said: “But as banks have understood the market better they have accepted two-way collateralisation, and that is now the norm.”

The amount of collateral required also fluctuates, as the value of the swap grows and shrinks in line with interest rates or inflation. Ahmad said that the collateral requirements are typically updated on a weekly or daily basis, and that moving from weekly to daily collateralisation is an easy process.

However, despite the largely orderly way that swap strategies have handled the crisis, pension schemes are partially retreating from the swaps market, according to consultants.

The older and more traditional approach to hedging liability risk is to move into fixed income, including inflation-linked bonds, where yields are explicitly tied to rates. This carries a higher up-front cost, and in the long term it also means that assets cannot be used for anything else, such as investment in absolute-return funds that aim to add substantial value over cash.

Kevin Adams, head of institutional fixed income at Henderson Global Investors, said: “Interest-rate swaps became progressively more expensive relative to gilts, meaning that yields have fallen. In October we saw a very rapid move in the swap spread down to below -40 basis points, so swaps were yielding significantly less than gilts. That is a big move, and since then it has been partially but not completely reversed.”

Pension schemes may find the timing is opportune to move back into the bond market. Adams said: “Even if some pension funds have a swap structure in place, there may be a rationale for them to unwind the swaps and replace them with inflation-linked or corporate bonds. The yields are very high and a well-diversified portfolio may be more attractive for liability-matching.”

Investment bankers see the same thing happening. Benoit Chriqui, head of European inflation trading at Barclays Capital in London, said: “Recently, pension funds have taken an interest in the fact that inflation swaps are expensive compared with bond break-evens, and have started to move out of swaps back into bonds. The resulting swap supply has given liquidity to the swap market and has helped to stabilise levels.”

Nevertheless, it is unlikely that pension funds will abandon the swaps market entirely. Watson Wyatt’s Horsfall said his firm’s clients have put on an extra £1bn’s worth of inflation and interest-rate protection in the past six weeks alone.

But he added: “Certainly index-linked gilts are in favourable territory, and credit levels seem quite interesting. It could be a good time to get some protection, but you do need to judge it.”